This essay is an economic analysis of the fundamental causes of
business cycles. Although such analysis has value for investing, the
purpose of this essay is for understanding the fundamental economic
workings of society. Those primarily interested in investing will
benefit greatly from this analysis, which complements my investing
essay, Investing & Trading in
Equities: Art & Science.

I believe that the best explanation for business cycles in the modern
world comes from the
Austrian School of Economics. Within the Austrian School there is
general agreement that business cycles are primarily caused by the periodic
credit expansion and credit contraction of central banks. But there are
many details & questions concerning business cycles for which there
is no "orthodox" Austrian theory. My analysis is therefore
an Austrian theory of business cycles rather than
the Austrian theory of business cycles.

Many people treat business cycles as being due to imponderable forces
that come & go like tides. But no events are causeless, certainly
not tides. Business upturns & downturns have predictable features, such as the
fact that luxuries benefit more from upturns and suffer more from downturns
than necessities. Similarly, durable goods & technological goods benefit
disproportionately from upturns and suffer disproportionately in
downturns. For this reason durable goods production is a more sensitive
indicator of recession than retail sales — and this is most especially
true for producer durables (machinery & equipment) rather than consumer
durables (automobiles, furniture, etc.). Unemployment is regarded as a
lagging indicator of recession because businesses will try to cut costs
in many ways (reduced advertising, reduced capital spending) before resorting
to laying-off workers who have training & experience. Economists who blame
recession on excess inventories confuse cause & effect.

I do not believe that business cycles would be a feature of a free market
economy. Periodic massive misallocations of resources leading to unsustainable
booms and recessions would not occur in an economy in which most of the
forecasting & resource-allocation was done by entrepreneurs rather than
bureaucrats. But there is no free market in money or short-term interest rates
anywhere in the world — central planning and control of money &
short-term interest by governments is universal. All contemporary currencies
are the product of government fiat, banking is controlled by government
central bankers and there is severe government regulation of the
financial sector.

All downturns and misallocations of resources in an economy cannot
be blamed on governments or central bankers. A massive earthquake in Japanese
urban centers or the simultaneous hijacking of passenger airplanes for use
in suicidal terrorist attacks are severely economically disruptive.
But these are events, not cycles.

For most of human history there was an obvious role of government
in disturbances of economic resource-allocation due to
warfare. Near the turn-of-the-millennium it began to appear that major
wars were becoming a thing of the past. Government ownership of
economies (socialism) began giving way to privatization of industries
that governments would then regulate. And a trend began towards
deregulation. But despite the trend toward deregulation, governments still
have firm control of money & banking — and there is little indication
that this situation will change soon.

The activities of central banks — which are national entities — gave
rise to a theory of business cycles by the English Economist
David Ricardo, who built on the anti-protectionist arguments of the
English philosopher
David Hume. In classical economics there was general agreement that
recession is the result of misallocation of productive resources. Warfare often
disrupts resource-allocation, and to the extent that warfare was
a periodic phenomenon, it could explain business cycles. Aside from
warfare and seasonality, however, there would be no explanation for
periodic misallocations of resources were it not for government
control of money.

According to Ricardo, English banks (with the backing of the English
central bank) could expand credit by making loans in excess of gold
reserves held by the banks. The result of this credit expansion was an
inflationary boom in the English economy. But as the price of English goods
rose, English consumers increasingly bought goods from abroad (which were not
selling at such inflated prices). At the same time, foreigners would buy
fewer English goods because of the inflated prices. As foreigners increasingly
redeemed their English bank notes for gold, the gold flowing out of England
resulted in rapidly diminishing gold reserves. Eventually, banks would have so
little gold that the credit expansion would be unsustainable and the banks
would be forced to contract credit to reduce the excessive pyramiding upon
dwindling reserves. The contraction of the money supply
would cause prices to fall and the loss of credit would suddenly stifle
business activity — resulting in unsold inventories, unemployment and
general depression. The price deflation would reverse the balance of
payments causing exports to exceed imports. Gold would flow into England
and the cycle could begin again.

Of course, Ricardo's analysis of England was a theory of business cycles
which could be applied to any country — with rising prices & increasing
production characterizing an upswing and falling prices & decreasing
production characterizing the downswing. The Austrian theory of business
cycles updates Ricardo's theory by focusing on the more subtle manipulations
of money & credit as exercised by central banks since the beginning
of the 20th century.

Austrian analysis asserts that in a world of hard money and
free banking, the inflationary forces of credit expansion due to
fractional reserve banking would not exist. If banks were warehouses
of commodity money — gold, for example — then currency would consist
of bank notes representing claims on the gold held by a bank. Any bank
that made loans in excess of its reserves (fractional reserve banking)
would soon find itself insolvent when other banks demanded hard money in
exchange for checks & banknotes issued by that bank.
This effect on banks is entirely
analogous to the effects on countries that occurred after World War I
when most nations attempted to implement a fractional reserve gold
standard for their currencies. Countries issuing large amounts of currency
backed by small amounts of gold found themselves in trouble when other
countries sought to exchange currency to obtain gold. (See
History of Modern Monetary Standards.)
Banks in a free banking system would face similar pressures against
fractional gold backing for their banknotes.

According to Austrian Economists, fractional reserve banking only
became possible through the outlawing of private money and the creation
of central (ie, government-controlled)
banks — which allowed governments to control money supply and bank
credit expansion.

In a free market interest rates are determined by subjective
time-preference and the supply & demand
of loanable money. If there is a low rate of savings the quantity (supply)
of loanable money will be low and competition for this money (demand) by
potential borrowers will result in high interest rates. High interest rates
will encourage more savings and thereby bring the price of loans (interest
rates) downward. As with supply & demand for any good
or service, a free market will find a "clearing price" for the
supply & demand of loanable funds. This clearing price is the natural
rate of interest.

The natural rate of interest plays an extremely important role in the
capital structure of an economy. Entrepreneurs/capitalists base decisions
on whether to begin long-term capital projects based on interest rates. If
interest rates are low, then borrowing to build a new factory, invest in a
telecommunications network or assemble the capital goods for a new business
venture appears feasible. Supply & demand of loanable funds will respond
gradually to adjustments in business activity. If business investment
(competition for loanable funds) rises, so too will interest rates —
reducing borrowing for investment.

Central bank control of money & short-term interest-rates in national
economies is at the root of contemporary business cycles. (For background
on the mechanics of short-term interest-rate manipulation by central banks, see
Money-Creation by Banks and
A "Managed Economy" Under the Federal
Reserve System.) When central banks artificially lower short-term
interest rates below natural market levels, this results in two major
distortions in capital markets. First, those who would save money receive
less than the natural rate of interest — and this disincentive to save
actually reduces the amount of loanable funds in real (as distinct from
nominal) terms. Second, those who would borrow money for large capital
projects are paying less than the natural rate of interest — thus
encouraging borrowing investors to believe that capital projects are
more sustainable than they really are.

Artificial lowering of interest rates by central banks is thus
accompanied by expansion of the money supply — resulting in an artificial
stimulus to spending for both consumer goods and capital goods. This
artificial stimulus results in an inflationary boom
which is not sustainable.
Central banks are ultimately forced to raise short-term interest
rates to counteract the inflation, resulting in a bust.
Supporters of central bank monetary manipulation justify the practice
as a means of leveling-out the business cycle when, in fact, central
banker monetary manipulation is the cause of the
business cycle!

In the 19th century, when money was based on gold & silver rather
than government fiat, economic growth was mildly deflationary — because
increased productivity lowers production costs. Inflation follows from
government expansion of money supply and is not the result of an
"overheating" economy that is growing rapidly. A distinction
should be made between non-inflationary economic growth due to
enterprise & technology and inflationary unsustainable booms due
to central bank interest-rate cuts. Lack of clarity
about this distinction has misled many economists into believing
that there is an upper limit to growth (about 3%) above which
growth is inflationary and unsustainable. Artificially low interest
rates increase consumption spending, reduce incentives to save and
increase investment spending with new fiat money that creates the illusion
of new wealth. After having expanded the
money supply with credit-expansion, central bankers worry that economic
growth is "overheating" the economy, and the bankers then
increase interest rates to "fight inflation".

This counter-inflationary elevation of interest
rates has a devastating effect on capital investment. Many projects which
formerly appeared feasible are no longer sustainable and must be abandoned.
Used capital equipment (computers, office supplies, etc.) floods the market
and manufacturers of this equipment are left with large unsold inventories.
Manufacturing slows, overleveraged businesses become bankrupt, employees
are laid-off and unemployed consumers reduce their spending. As a result
of the recession central banks lower interest rates to stimulate the
economy and the cycle begins again.

Austrian Theory emphasizes injection effects, asserting that
new fiat money (whether printed or created through credit-expansion)
disproportionately benefits the first recipients — bankers and
borrowers in the case of credit-expansion. But there is a price to pay
for the injection benefits received by corporate borrowers — namely
capital misallocation.

Control of economies by central bankers is a case study in mismanagement
& misallocation. The technocrats attempt to steer the economy by
looking in a rear-view mirror, ie, looking at government statistics on
previous periods.
Gross Domestic Product (GDP) includes government spending —
as if such spending is a measure of productive economic activity. In
compiling the statistic often regarded as the most important — the
unemployment report — the US Labor Department adds a "bias adjustment
factor" to account for newly started firms that the survey probably
misses. In the first half of 2001 this "adjustment factor"
amounted to well over half a million jobs — in an economy where newly
started firms were few and far between.

Market distortions also occur due to anticipations of central banker
behavior. When the central bank is on an "easing cycle" of cutting
interest rates, businesses often wait until the end of the cycle to ensure
getting the lowest rates. During the "waiting period" the economy
suffers.

The Austrian model of the structure of production is based on a
"goods-in-process" model of capital and a time-preference theory of
interest. In time-preference theory, interest rates are the supply & demand
for loanable funds — based on willingness to supply & willingness to
pay for transfer of funds for a specified period. A potential supplier of $100
may be willing to supply that $100 to a borrower for one year in exchange for
$6 (ie, 6% interest), but not in exchange for $4 (4%) interest.
A borrower may be willing to pay $4, but not $6 in a year's time in exchange for
$100. The market of such individuals will ultimately decide the final price
(natural rate of interest). In the goods-in-process model of capital, the
capitalist who has $100 invested in aging wine for a year receives
satisfactory interest in the wine can be sold for $105 (5%, ignoring
other costs) if the natural rate of interest is less than 5% — otherwise
the capitalist could more easily simply loan the money rather than risk tying
it up in capital (wine).

Any capitalist who invests capital in land, labor, manufacturing,
distributing & retailing facilities will expect to receive compensation
for both the risk of the investment and for the natural rate of interest
which would accompany a less risky loaning of funds. While the worker is
paid quickly for labor, the capitalist must wait for goods-in-process to
proceed through all stages of production to final sale. The longer the
wait, the longer the natural rate of interest associated with the
goods-in-process.

To produce a pencil, graphite must be mined and refined, then mixed
with clay and carbon-black. The manufacturer extrudes the paste through
a tube to form rods and then heats the leads to make them hard &
smooth. Wood that has been machined to form grooved slats receive the
lead tubes and are pasted sandwich-fashion. After adding paint &
eraser, the pencils are boxed, sent to warehouses and ultimately sold
by retailers. As with the aging wine, capital is tied-up while goods
are in process prior to final sale. In practice, the
manufacturer's goods-in-process structure of production is only a
portion of the goods-in-process structure for the pencil and of the
aggregate structure of production for all goods in an economy.
Processing raw fruits & vegetables for sale involves a much
less lengthy structure of production than is required for a
biotechnology company to research, test, and manufacture a new
drug.

The Hayek Triangle (Structure of Production)

Austrian economist
Frederick von Hayek (winner of the 1974 Nobel Prize in Economics)
introduced a graphical representation of the structure of production known
as the Hayek Triangle. The horizontal base represents the
time-dimension, usually depicted as goods-in-process, but which could also
represent time to build a new factory or complete research & development
on a new drug. The longer the base of the triangle, the longer the time
capital is tied-up before pay-back is expected. The vertical leg of the
triangle represents value of the consumable products of the production
process — the pay-back. The slope of the diagonal can be interpreted
as interest rate (ignoring the risk-of-capital factor). Simplistically, if
$100 is invested at the left corner of the triangle and if it takes one year
to reach the right corner and if the height of the right leg is equivalent
to $110, then the capitalist has earned a 10% return on capital.

In a growing economy both the vertical & horizontal legs of the
triangle are expected to lengthen. Artificial lowering of interest rates
by central banks distorts the triangle by creating incentives to stretch the
horizontal leg while at the same time reducing consumer savings &
increasing consumer spending (stretching the vertical leg). The
boom of malinvestment & spending is followed by a
bust of forced capital-project liquidation & reduced
consumer spending — shortening the length & height of the triangle
as the economy struggles to heal from the damage done by the central bank.

Although Austrian economics is purportedly an "a priori
science", the structure of production model was created to explain
why capital goods industries benefit more during a boom and suffer more
during a bust than consumer goods industries. Low interest rates and a
stable economy encourage industrialists to invest in productive assets
and encourage consumers to invest in mortgaging a house. But low interest
rates encourage investment only when the probability of profit (success)
is high and the probability of default (failure) is low.

Explanations are cheap & plentiful when compared to accurate
predictions in economics. From that point of view the Austrian School has
an advantage concerning the 1930s depression. Irving Fisher, father of the
Monetarist School, had become a millionaire from his invention of the Rolodex,
but was margined in the stock market at the time of the 1929 crash. Fisher
believed that the age of recessions had ended thanks to the new powers of
central banks to manipulate money supply & interest rates. Fisher
died heavily in debt to his family after having spent years paying-off
back taxes. Keynes too was caught by surprise during the crash, losing
three-quarters of the value of his portfolio. By contrast, in the summer of
1929 Ludwig von Mises refused a prominent position at the Kreditanstalt Bank,
telling his fiancee, "A great crash is coming, and I don't want my name
in any way connected with it." Kreditanstalt, Austria's largest
commercial bank (holding more than half of the country's deposits), failed
in May 1931.

According to the Austrian Business Cycle Theory, the 1930s Depression was
a consequence of the inflationary central bank credit expansion of the 1920s.
But the Federal Reserve had been extremely inflationary during the first
world war, doubling the money supply in the 1915-1920 period. The 1920-1921
recession that followed was sharp & severe — durable goods production
fell by nearly 50% in a short period of time. But the recession was
over in one year, possibly because wages were
permitted to fall while government reduced taxes & expenditures. In
Austrian Theory the deflationary forces of recession are the curative agents
of asset reallocation. By contrast, government policies in the wake of 1929
resembled those of early physicians who turned minor maladies into
life-threatening conditions through their blood-letting practices. The initial
causes of the 1930s Depression don't explain why it was so protracted.

Statistics cannot speak for themselves when so much insight is required
to interpret them. In his monetary history of the United States Monetarist
Milton Friedman denies that the 1920s was an inflationary period, pointing
to the relative stability of prices. But Austrian economists define inflation
by credit/money-supply expansion, not by prices — acknowledging that the
productivity growth of the 1920s boom caused prices to remain relatively
unchanged while money supply expanded. Similarly, GDP figures that include
government spending
distort reality in the implication that public works programs contributed to
economic growth in the 1930s.

Unemployment remained above 15% until the
Second World War. But the low unemployment & increase in industrial
production of military goods during wartime cannot be taken as signs of
prosperity, because the war accompanied rationing and great hardship —
destruction of life & wealth. Using a
deflator to correct for the high wartime inflation, Friedman & Schwartz
(MONETARY TRENDS, p.125) calculated that American per capita personal
consumption in 1944 was only 2% greater than it was in 1939. Real
prosperity did not return to the United States until well after World
War II. From 1920 to 1929 square feet of office space
doubled in Chicago, but between 1931 & 1950 not a single new office
building or large hotel was built in that city.

Federal Reserve Money Manipulation in the 1920s

The Federal Reserve ("the Fed") pursued distinctive monetary
policies through discounts, bills
(banker's acceptances)
and purchase/sale of government securities. But
the Fed's policies on time-deposits also contributed significantly to credit
expansion. Prior to the establishment of the Federal Reserve System, banks
were required to keep the same minimum reserve for both demand deposits and
time deposits. But after 1917, the Fed required only 3% reserve for
time deposits, compared to 10% for demand deposits (despite the fact
that time deposits are effectively demand deposits except for the fact that
they cannot be used for writing checks). From 1921 to 1929 demand deposits
increased 30.8% while time deposits increased 72.3%.

Although many economists had argued that the Fed's discount rate should
be high enough to be a penalty rate — making the Fed an emergency "lender
of last resort" — the rates were kept low enough that banks could profit
by discounting with the Fed and then relending to risky borrowers. The discount
policy was justified in the name of supplying adequate credit to
agriculture, industry & commerce — and was politically popular.

Unlike discounting, where banks obtain reserves only with an obligation
to repay — and unlike buying & selling of government securities at the
discretion of the Fed — the Fed set a low rate on bills bought (acceptances
— almost always
banker's acceptances), pledging itself to buy all those
bills offered at the cheap rate. This inflationary policy virtually created
the American acceptance market, with the Fed as the predominant buyer.

The Fed reduced the discount rate from 7% in 1921 to 3.5% in
early 1928, but raised it to 5% by the end of the year. In August 1929
the Fed increased the discount rate by 100 basis points to 6%,
an apparent attempt to dampen stock market speculation. The sudden
cutting-off of cheap money for capital uses & speculation was like
curing a case of hyperventilation with strangulation — reminiscent of the
Fed's tightening in early 2000 after pumping the economy with money in
late 1999 to avert a 1999/2000 Y2K rollover panic.

Aside from the effects of easy credit on speculative margin buying, the
stock market depends on the profitability or potential profitability of the
corporations whose assets are represented by the stocks. Industrial production
& the economy had begun to decline months before the stock market crash.
The S & P 90 peaked at 254 on September 7, 1929 and
stood at 245 on October 10th, but declined more sharply thereafter — crashing
on October 24. On October 29 the index
stood at 162, not far from where it had been in December, 1928.

A common myth holds that Herbert Hoover favored free markets, in contrast
to Franklin Roosevelt and the New Deal. In truth, Hoover was only slightly
less anti-capitalist than Roosevelt. The New Deal began with Herbert Hoover.

As Secretary of Commerce in the 1920s, Hoover had supported high tariffs
while at the same time subsidizing foreign loans, particularly for the export
of agricultural products. Although the 1920s were a time of economic growth,
agriculture, textiles and coal mining all suffered. People clinging to
tradition refused to adapt to a changing economy. From the 19th century
farmers had demanded inflationary policies (bimetallism, greenbackism) to
lessen their debt burdens.

In 1929 President Hoover established the Federal Farm Board to authorize
loans to farm cooperatives at low interest. Prices for wheat, cotton and other
agricultural products were supported by massive government purchases (much
given to the Red Cross) while the government searched for ways to subsidize
farmers to cut production to slow the rising production & falling prices.

The Smoot-Hawley Act raised tariffs to
the highest levels in American history, encouraging
international protectionist retaliation that hobbled world trade and
contributed to the world-wide depression. By 1932 American exports were
less than one third what they had been in 1929. To help support wages, Hoover
issued a decree through the State Department that reduced immigration from
Europe (the largest source of immigrants permitted by law) by 90% within
a matter of months. Hoover's policies actually kept real wages increasing
for those who remained employed — at a time when unemployment was
rapidly increasing.

DOW Index from 1920 to 1940

Public works projects, such as Boulder Dam (Hoover Dam) were greatly
expanded. Government spending was at a level of 14.3% of the gross
private product in 1929, 16.4% in 1930, 21.5% in 1931 and 24.8%
in 1932. While Hoover had initially supported a small tax cut that was
enacted at the end of 1929, burgeoning Federal deficits led him to support
the Revenue Act of 1932, one of the greatest peacetime tax increases in the
history of the United States. Personal income taxes were more than doubled
in most cases, estate tax was doubled and surtax maximums were raised from
25% to 63% on the highest incomes. Hoover created the Reconstruction
Finance Corporation (RFC) as a federal loan agency for organizations
that could not obtain money by other means. But supporting failing
businesses can cause more harm to the economy than good — especially when
financed by increasing the burden on taxpayers.

If Hoover had planned to inflict as much damage as possible on the
weakened economy, his policies were successful. From August 1929 to March
1933 non-durable manufacturing production fell 30%, durable goods
manufacturing fell 77%, department store sales fell 50%, the
value of construction contracts fell 90% and factory employment
fell 42%. Between 1929 and 1933 general prices fell 25% and
wholesale prices fell 37%. By 1932 over 25% of the entire
workforce was unemployed.

After having increased the discount rate to 6% in August 1929,
the Federal Reserve quickly changed course after the October stock market
crash, cutting the rate to 4½% by the end of 1929 and further
cutting until the rate stood at 1½% two years later. But in
September 1931 Britain — which had driven interest rates to 6% to
defend its fractional-reserve gold-exchange standard while the economy was
rapidly deteriorating — renounced gold convertibility. Within days, 24 out
of 47 nations on the gold-exchange standard also suspended gold
convertibility. The United States, with over 40% of the world's central
bank/treasury gold, lost one seventh of its gold stock within weeks — nearly
half going to France. To stem the tide, the US Fed increased the discount
rate by 100 basis points on October 9 and added another 1% a
week later — the fastest rate increase in the history of the Fed, before
or since. At 3½%, however, the discount rate was still near the
lowest levels of the 1920s.

Money and Banking Phenomena in the Early 1930s

Despite low interest rates due to growth in so-called
"high-powered money" (cash plus deposit liabilities of the
Fed to banks), money supply declined considerably in the 1929-1933 period due
to declines in bank deposits. The ratio of deposits to reserves declined from
an all-time high of 13.4 in April 1929 to 8.4 in March 1933. In
a fractional reserve system, every increase in reserves by the central
bank can increase money supply by a large multiple if most of the money
is loaned. But in recession, people
are more wanting to control debt than to borrow money. And confronted with
an economy presenting high risks of business failure, banks are more
reluctant to lend. Since the banks are lending much less money than their
reserves would permit, money supply can decrease even if reserves are
increasing.

Bank failures also contributed significantly to the large reduction
of deposits. The decline in agricultural exports and prices led to the
failure of many rural banks. Near the end of 1930 the failure of
Caldwell & Co.
bank destroyed the assets of many industrial & insurance companies. Within
months over 2300 other banks failed, leading to a precipitous decline in
deposits. Between 1930 and 1933 about one third of all US banks failed.
Monetarist Milton Friedman claimed that more money from the Fed would have
prevented this problem.

With the promise of balancing the budget, repealing prohibition, and a
"New Deal",
Franklin Roosevelt won all but six states in the 1932 election, and his
fellow Democrats won large majorities in both the Senate & the House.
Within days after assuming office at the beginning of March 1933 Roosevelt
closed all banks for 6 business days and suspended gold redemption. It
was the longest bank holiday in American history. This action
further undermined public confidence in the banking system. Deposit insurance
was introduced in 1934 under the Federal Deposit Insurance
Corporation (FDIC) and annual bank failures declined for the rest of the
30s. Whether the decline in failures was due to the FDIC or simply due to
the fact that the most insolvent banks had already failed is an open question.

Roosevelt continued many of the deleterious policies of Hoover, but
Hoover had already done most of the damage. Roosevelt won thousands of
farmers from the Republicans with his promises and he showed his gratitude
with a "domestic allotment" plan which paid farmers for reducing
production of seven farm commodities: wheat, cotton, corn, hogs, rice,
tobacco & dairy products. The
Agricultural Adjustment Act of 1933 raised prices
of agricultural goods by paying farmers for not planting. Many cotton
farmers plowed-under a quarter of their crops (55% of cotton had been
exported prior to the Smoot-Hawley Tariff Act). In 1933 six million
piglets and about 220,000 pregnant cows were slaughtered as price-support
measures. Cash income to farmers doubled between 1932 and 1936.

The Tennessee Valley Authority (TVA) was created in 1933 and the
RFC expanded its loans. In the winter of 1933-1934 nearly 4 million
unemployed people were temporarily hired for projects which even supporters
described as "make work". The
National Recovery Administration (NRA) was
created in 1933 on the theory that government regulation would make
business more efficient. Fourteen hundred NRA compliance officers imposed
price controls, minimum wages and a host of other regulations. A dry
cleaner was imprisoned for three months for charging five cents above
the NRA price for pressing suits. Industrial productivity dropped
25% within six months.

The largest New Deal agency was the
Works Progress Administration (WPA),
created to employ the unemployed in building infrastructure. By 1938
the WPA employed 3.3 million people. There were many accusations
of unneeded projects selected for political reasons (or from bad judgment)
and of low worker productivity.

Monetary policy during the rest of the 1930s was reasonably stable. The
discount rate was cut repeatedly in 1933 and from 1934 stood at 1½%
for nearly 3½ years. Then the rate was cut to 1% and remained
at that level for over 5 years. Both bank deposits and "high
powered money" grew at a uniform rate until 1940. Since the discount
rate was put above the short-term rate on commercial paper (making it a
true "penalty rate"), the use of the Fed for rediscounting
became relatively negligible. Hard money would have offered more stability,
but under the circumstances it was probably preferable to end the
fractional-reserve gold-exchange standard that passed for a "gold
standard".

Although unemployment remained above 15%, personal income and
industrial production rose significantly during Roosevelt's first term.
In the 1936 election Roosevelt won all but 2 states while the
substantial Democratic majorities were increased in both the Senate &
the House. With Mussolini in Italy, Hitler in Germany & Stalin in
the Soviet Union, freedom & capitalism were at their lowest ebb. But
1937 brought a severe recession within the depression, with durable goods
production dropping nearly 50% in a single year. Despite Roosevelt's
popularity as war-President, the high regard for his socialist policies
had begun to decline. When World War II ended and communists became
the new enemy, there was an increased appreciation for free-enterprise &
capitalism, even though it was heavily laden with Keynesianism.

Ignorance of market economics not only resulted in the New Deal, but
contributed to the 1930s spread of labor-based, class-warfare ideologies
— socialism, communism and unionism. Against this backdrop, the economics of
John Maynard Keynes was able to gain ascendancy. Keynes
attributed
business cycles to whimsical psychological forces and regarded government
intervention in the market to be a panacea. By moving even further
away from the gold standard, central banks gained a freer hand to engage
in inflationary practices. Keynesianism — with its emphasis on unemployment
& inflation and ignorance of the significance of capital — actually gave
governments a tool to undermine the devastating consequences of excessive
unionism. By inflating money supply, governments were able to drive down
real wages and thus counter the unemployment produced by the excessive
wage-rates of the unionists. Keynesian economists began to think an
inverse relationship between inflation & unemployment is a fundamental
economic law (the "Phillips Curve"). But although workers can
be fooled by an unexpected inflation, once government inflation tactics
are anticipated, unions will demand wage increases based on price
rise expectations.

Recession resulting from misallocation of resources (usually due to
government policies) require an adjustment period during which productive
resources become disengaged from producing goods not in demand and
re-engaged into the production of goods that are in demand. It does not
benefit the economy to try to encourage consumption of the inventories of
the goods overproduced due to resource misallocation — that would simply
encourage further misallocation. Even temporary labor unemployment benefits
society insofar as it allows for the shifting of labor from less productive
to more productive fields of endeavor.

Keynesianism encompasses other misconceptions about the economic
workings of society, some of which have fallen into disrepute and others
of which have a tenacious grip on the perceptions of policy-makers.
Keynesianism attributes "excessive inflation" to "excessive
spending" — and advocates countering excess inflation by increasing taxes
on consumers for the purpose of "sopping up their excess purchasing
power". The Keynesian cure for recession is to increase government
spending. Thus, Keynesianism emphasizes both fiscal policy (tax &
spend) as well as monetary policy (interest-rate & money-supply
manipulation by central banks) as tools for governments to control economies.
The double-digit inflation combined with recession ("stagflation")
of the 1970s caused increasing numbers of economists to question Keynesianism.

Early in the 20th century most borrowing was done
by governments for spending or by businesses for investment. Borrowing by
consumers was mostly limited to mortgages. But between the mid-1970s and
the end of the 1990s, the American personal savings rate as percent of
total income fell from over 10% to 0% — while consumer borrowing
ballooned. Extended periods of inflation made such practices prudent, but
these practices have persisted. Part of the decline of savings may have
been due to a shift from saving to the holding of equities, but
artificially low interest rates are also a disincentive for savings.

The 1980s Thatcher government in Britain and Reagan government in the
United States were inspired by
Supply-side Economics
and Monetarism
as alternatives to Keynesianism. Monetarism is similar to the Austrian
Theory of Business Cycles in criticizing periodic expansions &
contractions of money & credit by central banks. Monetarist Milton
Friedman advocated steady but gradual expansion of money supply by central
banks. Supply-side Economics holds that cutting taxes results in such economic
stimulus that tax revenues will increase — and no reduction in spending
is necessary (the "Laffer Curve"). [Use of the Laffer Curve in
Russia was more successful than in the United States. In the year 2000,
after having been told for years by the IMF to raise taxes, Russia cut
personal income taxes to a flat 13% from a top marginal rate of 30%
— with a resulting 50% increase in tax revenues.]

Both Monetarism and Supply-side Economics
were accompanied by ideologies supporting privatization & deregulation
— which were enormously beneficial to economic growth. The tax-cuts of
Reagan's Supply-side Economics did not result in compensatory tax
revenues, but were nonetheless a stimulus to economic growth in the 1980s.
Heavy military spending combined with the modest tax revenues resulted in
massive growth of government debt. A large government debt having an
artificially low risk premium (bonds and T-bills) significantly distorts
credit markets away from the natural rate of interest.
Monetarism also lost popularity, as governments shifted leftward, and
central banks reverted to their Keynesian attempts to manipulate the
economy through monetary policy.

Interest rate cuts by the US Fed (Federal Reserve, central bank) has
often been characterized as "throwing a party for Wall Street".
Treating the rate-cut as the party punch has been used as an analogy to
illustrate the difference between the Monetarist and the Austrian view.
In Monetarism the punch is regarded as a nonalcoholic, but delightful drink.
According to Monetarists, a central bank causes the business cycle by
occasionally mistakenly interrupting the upward trend by allowing
the money supply to contract (the
"plucking model" — from the analogy of
plucking a string). To Monetarists, the source of economic
growth is continued, judicious expansion of the money supply by the central
bank — and recessions are caused when central banks injudiciously increase
interest rates or refrain from lowering interest rates when it would
be appropriate to do so (plucking down the growth). For
Monetarists recessions are minor interruptions of growth, not "busts"
that follow "booms".

In the Austrian view the punch is spiked with drugs or large amounts of
alcohol. The drunken revelry boom of malinvestments is followed
by a hangover bust (forced liquidations of long-term capital
projects). The Austrian interpretation stresses that the net effect of the
Fed's action is reduced growth — below what would have been experienced
without the Fed's actions. Austrian analysis also differs from Monetarism by
emphasizing "injection effects" — the actual economic
distortions are the product of how & where the inflationary new money
enters the economy. Monetarists are indifferent to the path of new fiat
money, being concerned only with the total amount of money in the economy.

From 1950 to 1990 Japan was a model of economic growth unlike anything
the world had ever seen. From 1960 to 1975 Japan averaged a real GDP growth
of 10% per year — and averaged half that much growth in the following
15 years. An important reason for this economic miracle was the
remarkable frugality of the Japanese people, who saved nearly one third of
their income — money which was invested.

Japanese discount rate (ODR) and stock market

What followed, however, was a model of the Austrian Business Cycle
and the damage Monetarist & Keynesian remedies can do to an economy.
From 1980 to 1989 the Japanese Central Bank (Bank of Japan, BOJ) engaged
in a disastrous policy of credit expansion, driving the Official Discount
Rate (ODR) from 9% to 2½%. Massive overborrowing by Japanese
corporations was spurred not only by the artificially low interest rates,
but by the fact that the government effectively guaranteed the loans.
In that same period, the Japanese
Nikkei 225 stock index rose from less than 10,000 to nearly 40,000 on
a path of exponential growth. With 3% of the world's landmass, Japan
had 60% of the world's real estate value. These colossal overvaluations
also fueled overborrowing by making debt-to-equity ratios appear far
lower (and less risky) than they really were.

Horrified by the soaring prices
in stocks, real estate and the economy in general, the BOJ hiked short-term
interest rates (ODR) from 2½% to 6% in the space of a year
(1989-1990). To fight the escalating real estate prices, capital gains taxes
were raised on profits from the sale of land. The Japanese stock market began
a crash which took it from 40,000 in 1990 to 20,000 in 1992 and 10,000 in
2001. In 1991 Japanese real estate prices began a similar precipitous fall.

Equity markets have a real impact on the business community. Stable stock
prices and rising stock prices allow corporations to raise equity through
issuance & sale of stock and to use stock to make acquisitions of other
companies. Plummeting stock prices force corporations to resort to debt
rather than equity financing for capital maintenance & expansion — and
reduce the ability to use stocks & stock options as a means of
compensating executives & employees. When enough businesses face this
kind of capital crunch, many of them become financially insolvent, which
then reduces the solvency of the banks that loaned them money.

Japanese spending to "stimulate" the economy

Instead, the Japanese government turned to Keynesian "fiscal
stimulus" (deficit spending) as the means to economic recovery. The
government spending only served to divert economic resources from
market-guided productive activity which could have aided recovery. From
1992 to 2002 government debt rose from 50% of GDP to 125% of GDP
as the government littered the country with bridges that are hardly used.
Although income taxes were cut in 1994 & 1998, sales taxes were raised
in 1997 from 3% to 5% and government spending was not restrained.

As much as half of government "stimulus" spending went
to construction companies — political allies of the ruling Liberal
Democratic Party. Nearly 10% of the Japanese labor force is
employed in construction — a large voting block. The Japanese penchant
for savings has not benefited the economy because more than a third of
the money saved has gone to the postal savings system which buys
government bonds and thereby underwrites more government spending
(misallocation of productive resources).

The Japanese Monetarist monetary policy fared no better than the
Keynesian fiscal policy. The discount rate was cut to half a percentage
point by the mid-1990s (and was further cut
to nearly zero in 2001) in a vain attempt to stimulate the economy by
stimulating borrowing (what Keynes called a "liquidity
trap"). Stuck with excess inventories and poor
business prospects, companies were more concerned with reducing debt and
cutting costs than borrowing for capital equipment & expansion. An
increase in the monetary base from mid-1997 to mid-1998 of 10%
increased broader monetary aggregates by only 35%. Banks burdened
with bad debt and risky prospects are unwilling to lend.

By 2001 outstanding bank loans had fallen from year earlier levels for 45
straight months, with total loans falling below total deposits in early 1999.
Loans remained on the books of banks despite collateral asset values
(real estate, stock market equity & failed businesses) that have fallen
as much as 80% in the 1990s. The Bank of Japan policy of buying stock
equity from banks has benefited neither the banks nor the economy.
Loans to companies in danger of default were continually rolled-over. Government
loan guarantee programs & financing kept many technically bankrupt
small businesses afloat. The government also underwrote banks that otherwise
would have failed.

With a tradition of lifetime employment many Japanese companies went
for years without laying-off workers, despite reduced sales & production
— and huge losses. A cycle of deflation began in earnest in 1998 as
companies began cutting prices, cutting employees and cutting purchases
of supplies. Prices fell 1.5% in 1998 and 1999.

Monetarist economist Milton Friedman, "New Keynesian"
(ie, Monetarist Keynesian) Paul Krugman and others have advocated increasing
the money supply (reflation, to combat deflation) as the
solution to Japan's problems. The Bank of Japan (BOJ) has been told to
weaken the Yen by printing more currency and buying US Treasuries to
stimulate exports. Exports only constitute 10%
of the Japanese economy and a cheaper Yen would drive up the cost of oil
& other imports (and possibly lead to competitive devaluations by
neighboring governments). Inflation would only worsen Japan's problems.

In sum, the Japanese central bank created an inflationary economic
bubble of overspending & overinvestment by monetary expansion. When
the bubble burst, government underwriting of banks has allowed the
misallocation of resources to continue. More misallocation of resources
results from misguided government programs attempting
to save inefficient companies (and whole industries) producing goods
not in demand.
If loans were foreclosed and the businesses
were liquidated, the physical assets & employees could be re-directed
to more productive use. Government spending on construction and
programs to maintain unproductive employment has only served to further
misallocate resources while increasing national debt. The solution to
all these problems in Japan and elsewhere is the free market — abolish
central banks and eliminate government attempts to underwrite & stimulate
the economy — programs that waste money while directing resources away
from their most productive uses.

Procrustean theorists struggle to fit every event into their predefined
molds. But the economic boom of the late 1990s and the turn-of-the-millenium
bust involved important factors aside from the actions of central bankers.
The role of computers in business and spending on computer technology by
business was unprecedented in this period. The fear that the
Y2K computer bug would have catastrophic
consequences led to literally hundreds of billions of dollars
being spent on reviewing & upgrading computer systems. At the
same time, Internet & cell phone technology appeared to have the
capacity to radically alter the way people live & conduct business.

Technology & tools have always been the principle means by which
humans have increased their productivity. Computers have recently
played a major role in increasing worker productivity. From 1995-2000 annual
output per worker grew by 2.5% in the US as compared with an average
1.4% in the 1975-1995 period. The gains in Europe were only half
as great — a difference which a University of Groningen study by Bart van Ark
attributed to greater American deregulation in the industries that are the
heaviest users of information technology, such as finance and wholesale trade.
Other analysts, however, say that a big increase in part-time working in
Europe has also served to depress productivity growth.

In the 1950s three-fifths of financing for American commerce &
industry was through commercial banks. But in the 1990s that fraction had
shrunk to one-fifth, as companies increasingly financed themselves through
venture capitalists, common stock sales and initial public offerings (IPOs).

Stock markets surged upward as a result, technology stocks in particular.
An investor who had bought $1,000 of
Yahoo! stock at the time of
its April 1996 IPO would have had shares worth nearly $100,000 in
mid-2000. An investor who had bought $1,000 of
EMC Corporation stock
in 1990 would have had shares worth $1.6 million by the end of the decade.
The capital-goods intensive, technology-laden NASDAQ stock index grew at an
extraordinary pace, giving an 85% return for the year 1999.

The extraordinary economic growth in 1999 would ordinarily have been under
anti-inflationary attack by the Fed, but fears of panic at the time of
Y2K caused the Fed to print large amounts of money, to refrain from raising
interest rates and to keep lots of "liquidity" in the economy.

High returns attracted a great deal of money into the stock market.
By the end of the 1990s fully half of Americans had some form of investment
in the stock market, an unprecedented level of stock market participation.
On-line investing became a national pass-time. A nation of people that invests
in equities does far, far more to benefit the economy than a nation of
spenders. Investment, not spending, is the engine of economic growth — and
US growth rate began to exceed 5%. Growth in capital goods
& technology accelerated productivity faster than money-supply expansions
& government-spending increases — thereby limiting inflation and allowing
governments to accumulate surpluses.

Buying stock provides companies with equity that can be used to conduct
research, expand into new markets and grow. Stock with appreciating value
can be used like cash by companies to compensate employees and to acquire
other companies. As long as stock prices were appreciating, investors were
not concerned about receiving dividends — allowing companies to use their
retained earnings for further expansion. Investors were also very forgiving
about lack of earnings for new companies with new technologies attempting
to establish themselves. Stock market investors who are willing to take
the risks of venture capitalists can be richly rewarded — as in the case
of Yahoo! investors who
earned a 5,000% return in 5 years despite the fact that there were
no earnings until 3-and-a-half years after its IPO (and even those
"earnings" were pro forma).

When the Y2K turnover came & went without catastrophic consequences
there were bound to be large reallocations of capital. After such massive
expenditures on upgrading computer hardware & software in preparation
for a possible disaster, businesses would naturally be expected to refocus
spending on areas that had been neglected due to the urgent computer-related
deadline of January 2000.

In the Spring of 2000 the US Federal Reserve resumed a stringent policy
of raising interest rates in the name of preventing inflation.
US Unemployment levels were at record lows, crime rates were at record
lows, stock market levels were at record highs and economic growth was very
high. Although the Fed had expanded the money supply considerably in
previous years, thereby satisfying the Austrian definition of inflation,
growth in productivity had been strong enough to counter central bank
policies — prices remained stable.

Although Fed Chairman Greenspan denied under Senate testimony that he
was targeting the stock market, references in this speeches to the
inflationary "wealth effect" associated with rising stock prices,
unsustainable returns and rates of growth, etc. caused many to question his
credibility. Greenspan said under testimony that by raising interest rates
the Fed would prevent possible future inflation. Short-term interest rates
were pushed so high that the yield curve inverted, ie, long-term rates were
actually less than the short-term rates controlled by the Fed, suggesting
that the market was anticipating the disinflationary/recessionary effects
of central bank credit contraction.

A more devastating and immediate attack on the American Economy,
however, came from the Justice Department, which branded Microsoft
Corporation a monopoly and threatened to break-up that company in the name
of consumer protection. Microsoft lost $70 billion in market
capitalization in a single day — on one ruling — and eventually
lost hundreds of billions as the Justice Department continued its assaults.
Technology is an intricate web of interdependence and this is especially
the case with MicroSoft. Very many company's fortunes were tied to products
built around MicroSoft. The devastating damage to MicroSoft had a domino
effect across the whole technology sector — including MicroSoft's
competitors and eventually the whole economy.

Rather than describe the Internet "dot-com" startups as
the product of irrational investor mania, they could be viewed as the
equivalent of long-term capital projects of Austrian Business Cycle
Theory. The new Internet companies were usually years away from
profitability and were predicated on the assumption that the
economy would continue to grow — and the Internet along with it. But
the boom had been the artificial boom of central bank credit expansion
followed by the bust (recession) provoked by sudden central bank credit
contraction.

Austrian business cycle theory does not preclude faddish investments
driven by investor psychology. Assets such as tulips that are attracting
investor attention can result in price increases that reinforce the
expectation that prices wil continue to increase. Artificially low
interest rates can help provide artificial capital that helps feed
the mania of malinvestment.

For the whole of the year 2000 the Federal Reserve maintained high
interest rates, seemingly indifferent to the fact that the NASDAQ had
lost half its value and that the economy was rapidly deteriorating. In a
free market for money, interest rates fall as economic conditions worsen
because businesses have fewer opportunities and are more concerned with
managing debt & costs — an effect which lessens the burden on
debt-strapped companies. But central bankers are bureaucratic central planners
guided by backward-looking government statistics rather than market forces.
Central bankers can do as much damage by credit contraction as by inflationary
credit expansion. Only in January 2001 did the Fed begin to cut interest
rates — continuing to cut rates very aggressively through the whole of
the year 2001.

Some critics of Austrian Business Cycle theory have suggested that savvy
entrepreneurs would anticipate the effects of central bank credit
expansion/contractions, thereby reducing the intensity of business cycles.
Austrians have responded that it is more difficult to forecast government
actions than consumer demand. Nonetheless, the fact that interest rates on
long-term bonds remained relatively unchanged through most of the year 2001
suggests that the market was anticipating the inflationary effects of central
bank credit expansion.

Nor did the market respond much to the "economic stimulus" of
central bank rate cutting through most of 2001 (expanding M3 growth
from an annualized 10% to 14% — the fastest money supply growth
in 20 years). As in Japan, central bank
attempts to encourage borrowing through artificial lowering of interest rates
could not succeed at a time when economic deterioration is forcing businesses
to cut costs & reduce debt. The ineffectiveness of interest rate cuts
under such conditions has been called "pushing on a string" — in
reference to the fact that a piece of string is not a rigid body and will
simply curl around the finger when pushed. Since capital spending is cut
significantly when economic conditions deteriorate, productivity growth
and technological innovation declines. The year 2000 was the first year
since 1994 that the number of assigned patents dropped (falling 2.3%).

Although the American housing market boom and bust of the first
decade of the millennium was associated with an artificial
credit expansion, the impact was not concentrated on capital goods
and the central bank was not the only responsible agent, unlike the
case for the classical Austrian business cycle scenario. The Federal
Reserve was no less responsible than the Government Sponsored
Enterprises (GSEs) Fannie Mae and Freddie Mac.

Fannie Mae (the Federal National Mortgage Association)
is a government agency created in 1938 which monopolized the
secondary mortgage market in the United States until 1970. In 1968
Fannie Mae was converted into a shareholder-owned "private
corporation". In 1970 Freddie Mac (the Federal
Home Loan Mortgage Corporation) was created, and in 1989 it was
made a GSE modeled after Fannie Mae.

The purpose of both GSEs was to make borrowing for home ownership
easier for Americans, especially those of limited financial
means. Neither GSE issues mortgages directly. Instead they purchase
mortgages from banks & other lenders and convert those loans
into mortgage-backed securities which are sold like bonds. The GSEs
guarantee that the principal & interest for all mortgages they
purchase will be paid whether or not the homeowners default.
The GSEs charge a fee for assuming all credit risk.

Although ostensibly private companies, there was a widespread (and
ultimately vindicated) perception that the federal government
would not allow the GSEs to fail. The GSEs were given
monopoly
privileges against which no true private enterprise could
compete. Five Board members of both GSEs were appointed annually by
the President of the United States. Both GSEs had a line of credit with
the US Treasury Department, and both were exempt from state & local
income tax on corporate earnings. Fannie Mae Discount Notes became
the second-largest short-term notes issued — second only to
T-Bills, and paying a yield that reflected implicit government
backing. From the 1990s both GSEs held rather than sold most of
their mortgage-backed securities — issuing debt below the yield
of the securities and profiting from the spread. FDIC Bank Holding
Company Act requirements that impose capital/asset ratio minimums
of 3% on other financial institutions made no such requirement
of the GSEs. Shareholders pressured the GSEs to take more risky
loans so as to enhance profits. Those originating the loans became
less wary of risks because they were able to transfer the risk
to the GSEs.

Subprime loans are often considered to be loans made at
high rates of interest to people with poor credit (a
FICO credit
score of less than 660). But at the peak
of the subprime lending boom — 2005 & 2006 — most subprime
loans were made to people with good credit, but who were borrowing
more than their assets or income could justify. Many borrowers (both
prime and subprime)
obtained Adjustable-Rate Mortgages (ARMs) which were tied
to federal interest rates, but gave lower initial interest as
a sweetener. In 2005 43% of first-time buyers purchased their
homes with no down payment, and the median down payment for a
$150,000 home was 2%. This can be compared to an average
down payment of 18% for first-time buyers in 1976. By 2006 20%
of the entire mortgage market was subprime, and 81% of those
loans were securitized.

Both GSEs increased
subprime mortgage purchasing in the 1990s. The GSEs operated relatively
free of congressional oversight and market discipline. When a
congressman made public the outrageous compensation received
by GSE executives they threatened to sue him. Near the end of the
Clinton administration the Department of Housing and Urban Development (HUD)
imposed "affordable housing" quotas on the GSEs.
These quotas were later increased under the Bush administration —
lowering mortgage requirements even further so more people could buy
houses they couldn't afford. By 2007 HUD required that 55% of loans
made by the GSEs be to borrowers at or below median income.

In 2003 — when the GSEs were the only two Fortune 500
corporations exempt from
Securities and Exchange Commission (SEC)
regulation — three Freddie Mac top executives were ousted
for obstructing an accounting probe. Freddie Mac was fined $125 million
by the
Office of Federal Housing Enterprise
Oversight (OFHEO) for understating earnings by $5 billion.
In 2006 the OFHEO fined Fannie Mae $400 million for accounting fraud.
In April 2006 Freddie Mac was fined $3.8 million by the
Federal Election Commission (the largest fine in FEC history)
because of illegal campaign contributions, much of which had
benefited members of the House Financial Services Committee.

Fed Funds Rate

By 2008 the two GSEs owned or guaranteed about half of the
$12 trillion worth of mortgages in the United States,
including at least 70% of new mortgages being issued.
Mortgage lending had become so politicized that the GSEs
were required to have at least 56% of their mortgages
with individuals having below average income, and at least
35% of the mortgages had to be in geographic areas deemed
to be underserved by other companies.

The "housing bubble" began bursting in
2006. The Federal Reserve had played its role in the
credit expansion and collapse that led to the liquidity
crisis. The Federal Funds Rate was slashed from 6.5% in
January 2001 to 1% by June 2003. After one
year at 1% the Fed ratcheted rates back up to 5.25%.
Conventional 30-year mortgage rates fell from about 8.5%
in 2000 (10% in 1990) to below 6% in 2003, remaining
mostly below 6% until late 2005, peaking to about 6.5%
in the summer of 2008. One-year Adjustable Rate Mortgages (ARMs)
dropped below 4% in 2003, but rose to about 6% in 2006.
Because of lower mortgage rates, lax lending practices and
ever-increasing housing prices, real estate loans more than
doubled between 2001 and 2008. In 2005 & 2006 40%
of home purchases were not primary residences. 28% of the
homes purchased in 2005 were for investment and 12% were
vacation homes.

Nationally, housing prices peaked in 2005, although regional differences
were large. Between 2001 & 2006 Miami, Los Angeles and Phoenix saw
80% price appreciations, but prices appreciated less than 10%
in Dallas, Detroit, Denver and Atlanta over the same period. The states
with the highest subsequent foreclosure rates were California, Florida,
Michigan and Ohio. The first two states had seen price appreciations
above 80% in the 1998 to 2006 period, but the second two were
among the states with the lowest price appreciations.

S&P/Case-Shiller US National Home Price Index

With Fannie and Freddie assuming the risk, by 2008 40%
of subprime loans were generated by "automated underwriting".
Between 1994 and 2003 subprime mortgage loans increased ten-fold.
As interest rates began to rise, however, so did the mortgage
default rate. In 2007 there were 1.3 million US homes
subject to foreclosure, up about 80% from 2006. In March 2008
the delinquency rate on subprime loans having Adjustable Rate
Mortgages was 25% — a five-fold increase from
2005. By August 2008 more than 9% of the entire
$12 trillion US mortgage market was delinquent, and by
September house prices had plummeted to the point
where 18% of homeowners had negative equity
(homes worth less than their mortgages).

In March 2007 Fannie Mae terminated its agreement to buy mortgage
loans from New Century Financial Corporation, the second biggest
subprime mortgage lender in the United States. New Century filed
for bankruptcy the next month, and the bankruptcy examiner later
charged that New Century's auditor had colluded in concealing financial
problems. In July 2007 the investment bank Bear Stearns disclosed
that two of its subprime hedge funds had lost nearly all of their
value due to the meltdown of the subprime mortgage market. Shortly
thereafter investors initiated legal action against the bank.
By March 2008
the insolvency of Bear Stearns was prevented when the firm signed
a merger agreement with JP Morgan Chase for a stock swap worth
$2 per share of Bear Steans (down from $172 per share in
January 2007) and a $29 billion
non-recourse loan
from the Federal Reserve to compensate Chase for the risk of
assets the company was accepting.

The subprime mortgage crisis did not remain confined to
the United States. Northern Rock, one of the top mortgage
lenders in the United Kingdom, began subprime lending in 2006
with Lehman Brothers underwriting the risk. In September 2007
there was a run on the bank, resulting in two billion pounds
being withdrawn before the British government announced that
it would guarantee all Northern Rock deposits. In February
2008 Northern Rock was nationalized. The
Basel Accords, which provides rules
for international banking, mandated that banks have
capital reserve of 8% for corporate loans, 4% for
mortgages, but only 1.6% for mortgage-backed securities
— creating an incentive for banks to hold mortgage-backed
securites. Sovereign debt
(government debt) is regarded as
risk-free by the Basel Accords, and hence requires
no capital reserve. The American
Securities and Exchange Commission (SEC)
mandated that the largest United States investment banks comply
with the Basel Accords — further contributing to the
financial meltdown in the USA.

On July 11, 2008 IndyMac — the seventh largest mortgage
originator in the United States — was seized by the
Federal_Deposit_Insurance_Corporation (FDIC)
when the bank failed. On September 7, 2008 Fannie Mae and Freddie
Mac were taken over by the federal government and placed under
conservatorship of the
Federal Housing Finance Agency (FHFA)
(a virtual nationalization of the mortgage industry). Common stock
of the GSEs, which had been trading at close to $80 per share for
most of the decade, was soon below $1 per share (delisted from
the New York Stock Exchange on June 16, 2010).
Dividends on the preferred shares of the GSEs — held by
many commercial banks — were suspended. The financial
obligations of the two GSEs were estimated to be about
$5 trillion, close to half the value of the federal
national debt. The US Treasury Department pledged
$100 billion to each GSE to maintain solvency.

On September 15, 2008 Lehman Brothers investment
bank filed for the largest bankruptcy in United States
history (IndyMac Bank had been the ninth largest).
Lehman had closed its subprime lender, BNC Mortgage,
a year earlier, but was still holding large positions
in mortgage-backed securities which had huge losses
in 2008. September 12 was the maturity date of more
than $1.2 billion in unsecured loans that Lehman
owed Freddie Mac. Also on September 15, rating agencies downgraded
the credit ratings of the
American International Group (AIG)
insurance company
forcing AIG — which had valued its subprime mortgage-backed
securities at nearly twice the rates used by Lehman — to
deliver $10 billion in collateral to creditors. Two days later
the Federal Reserve confirmed that it had taken a 79.9% share
in AIG in exchange for an $85 billion rescue package.
AIG executives were under criminal investigation for
misleading investors about how much the value of the
company's credit-default swaps had declined. AIG had begun
selling swaps that served as insurance against credit-default
in 1998, and in 2004 expanded into swaps against defaults
on Collateralized-Debt Obligations (CDOs) backed
by securities such as mortgage bonds, auto loans and credit-card
receivables. The computer models AIG had used to assess the
risk of these Credit-Default Swaps (CDSs) did not account
for potential write-downs or collateral payments. AIG had considered the
risk of substantial payout to be small "even in severe recessionary
market scenarios."

The credit crisis was worsened by the mark-to-marketFinancial Accounting Standard 157 (FAS 157,
enacted in 2007) which requires businesses to price their assets at the
lowest price for which similar assets have been sold. The
SEC forced banks to value their mortgage-backed
securities, credit default swaps (CDSs), and similar assets
by FAS 157. Financial institutions
feared buying mortgage assets strictly on the basis of future cash
flows, anticipating future mark-to-market paper losses that could
undermine their regulatory capital and credit ratings. Weak institutions
forced to sell their CDOs and mortgage assets at "fire sale"
prices weakened the financial position of more credit-worthy
institutions which were forced to slash the value of mortgage
backed securities below the price that would be justified by cash flows
(mortgage payments). The stronger institutions were thereby weakened
and forced to sell assets of their own to meet minimum
capital (or collateral) requirements, creating a downward spiral of
asset devaluations, credit downgrades, forced sales and bankruptcy.

Worsening the viscious-cycle, downward-spiral associated with
mark-to-market accounting was the viscious-cycle, downward-spiral
associated with ratings downgrade triggers. The credit ratings
given by credit rating agencies (which assign credit ratings
to various kinds of debt) affect interest rates and collateral required
for debt obligations. The SEC-sanctioned rating agencies had been
assigning triple-A ratings to junk mortgage paper, and SEC rules
required money-market funds and stock brokerages to hold securities
highly rated by the agencies. Credit rating downgrades can automatically
trigger a requirement to post additional collateral for debt. A
struggling company forced to sell assets at firesale prices to
meet the additional collateral requirements can then be faced
with another ratings downgrade — a "death spiral".
AIG failed because of a ratings downgrade on its CDS contracts.
The Lehman bankruptcy resulted in AIG being unable to find a
market for the assets it had to sell to meet the increased
collateral requirements.

On September 22, 2008 Goldman Sachs and Morgan Stanley, which
had been the last surviving investment banks, transformed into
commercial bank holding companies, similar to Citicorp and Bank
of America. Lehman Brothers had gone bankrupt, Merrill Lynch had
been bought by Bank of American, and Bear Sterns had been bought
by J.P. Morgan Chase. With no more investment banks, most
U.S. financial institutions were regulated by the Federal
Reserve. (SEC bureaucrats lamented their loss of importance.) As
commerical banks, Goldman Sachs and Morgan Stanley no longer
were required to value their assets by mark-to-market, and
would have acccess to funding by bank deposits rather than
money market borrowing. Investment bank leveraging had soared
in recent years (Merrill Lynch leverage ratio of assets to
capital had gone from 15 in 2003 to 28 in 2007, and Morgan
Stanley's had gone to 33), but as commercial banks leverage
would need to be close to 10. Moreover, the banks would have
access to short-term borrowing from the Fed. The Bank Act
of 1933
(Glass-Steagall Act) had separated
securities trading (investment banking) from lending
(commercial banking) in the interest of protecting depositors.
With no more investment banks left, it was an open question
whether the Fed would also seek to regulate hedge funds.

The collapse of the credit market and stock
market in the United States was followed by a stock
market and credit market bloodbath worldwide — not
surprising in light of the US debt and equity holdings
of foreigners. The 2007 foreign holdings of US GSE
debt was $1.3 trillion, 29% of which was
held by China, 17.5% by Japan and 5.8% by
Russia. Hong Kong investors
who had purchased US$2.6 billion in risky Lehman
Brothers products held protests.

On October 3, 2008 the US federal government
enacted the Emergency Economic Stabilization Act of
2008 empowering the Treasury Department to purchase
up to $700 billion in distressed bank assets,
(especially mortgage-backed securities) through the
Troubled Assets Relief Program (TARP).
Although TARP was based on the supposition that removing
"toxic assets" would restore the financial sector
to health, there was considerable controversy & confusion
in the government about the pricing of those assets. Use of
mark-to-market pricing might not help the financial industry
very much, but paying too much would leave politicians vulnerable
to accusations of "welfare to the rich" at taxpayer's
expense. The Treasury Department abandoned efforts to buy toxic
assets. On October 14 the Treasury Secretary announced a decision
to instead use TARP money to buy preferred shares of the nine
largest American banks. In purchasing
preferred shares of banks, the US Treasury subsidized
those with bad credit practices as well as the more
stable ones (who had no choice but to comply) —
thereby rewarding and providing incentive for reckless &
incompetent financial practices. The statutory
limit on the national debt was increased from
$10.6 trillion to $11.3 trillion. Interest
rates were cut and proposals made to increase credit
by other means. Many banks were able to repay TARP loans thanks
to their ability to sell more than a trillion dollars worth
of GSE-guaranteed MBS securities to the Federal Reserve.

Interest Paid by the Fed on Excess Reserves

Interest Paid by the Fed

Excess Reserves

In October 2008 the Federal Reserve took the unprecedented action of paying
interest to the banks on the money they held that was in excess of their minimal
reserve requirements. Banks had historically held a "relatively negligible"
amount of excess reserves with the Fed, but the $2 billion held at the end of
August 2008 had climbed to $1.5 trillion by the end of 2012.
Banks historically loaned-out nearly all of their allowed reserves, but with
the prospect of loan defaults in a weak economy, and with the 0.25% interest
they were being paid by the Fed, banks found it more prudent to keep excess
reserves. The Fed theoretically artificially lowers interest rates to encourage
borrowing by consumers to stimulate the economy, but by paying interest to
banks for not loaning money (to prevent inflation) the Fed is engaging in a
contractory (and expensive) policy, in addition to the damage it does to credit
markets by interest rate manipulation that discourages savings.

TARP was
originally intended only to help banks that were relatively healthy.
But Massachusetts congressman Barney Frank (head of the
House Financial Services Committee, who had earlier
told the New York Times that claims
that the GSEs had financial problems were exaggerations)
added a provision that would
give special consideration for certain banks that had lost substantial
equity due to large holdings of GSE stocks and bonds — as
well as banks which served low-income families. Frank made
no secret of the fact that he was particularly
concerned about OneUnited Bank of Boston in his home state. In
October, 2008 the FDIC and Massachusetts regulatory officials
took enforcement action against OneUnited on grounds of
poor lending practices and executive compensation abuses.

In September 2008 the Bank of America had agreed to buy Merrill Lynch.
But by December, when Merrill's massive losses were showing no
limit, Bank of America decided they had ample legal grounds to stop
the deal. Federal Reserve officials warned that if the Bank of America
was in future need of federal bailout money, the government would
consider ousting executives and directors. Within a month a deal
had been reached for the Bank of America to purchase Merrill with
the aid of $20 billion in government money plus $118 billion
in troubled asset loss protection. In 2008 the Bank of America had
spent $4.1 million in lobbying, and Merrill Lynch had spent
$4.7 million.

With the collapse of US credit markets the US Dollar strengthened
significantly against most other currencies, a consequence of
fractional-reserve banking that caught many
by surprise. Then, in an effort to "combat deflation,"
the US Federal Reserve drove the fed funds rate nearly to zero.
The Fed poured massive
amounts of newly created money into the economy by buying commercial
paper, mortgage-backed securities and bundled credit-card debt,
among other things — increasing Fed reserves by more than
an order of magnitude, weakening the US Dollar against other currencies.

Cause of the financial crisis(CONSUMER REPORTS poll)

Poor lending practices

27%

Lack of government oversight

26%

Wall Street greed

19%

Excessive consumer borrowing

15%

The 2008 Presidential candidates blamed the financial crisis
on "capitalist excesses", "predatory lending
practices" and "excessive deregulation".
Both parties promised to "clean up Wall Street"
and impose stern regulation of the financial sector. Months
after the election, public outrage was directed against AIG
employees who had been pledged retention bonuses to stay with
the troubled company — as if they had been the ones
responsible for AIGs unhedged mortgage swaps. In a CONSUMER REPORTS
poll, 26% of respondents blamed the financial crisis
on lack of government oversight, and 78% of respondents
wanted increased regulation of financial institutions [CONSUMER
REPORTS; 74(1):24-27 (2009)]. This is ironic in that it was
pressure from regulators and politicians which had been
the driving force behind the subprime mortgage market
and the securitization of that debt. Once again, disastrous
regulatory policies (combined with government incompetence &
corruption) that cause economic disaster leads to a public
outcry for increased regulation.

The Financial Crisis Inquiry Commission appointed by
the US government to determine the cause of the financial crisis
concluded that lax regulation and faulty risk management by
households and Wall Street were to blame. GSEs were held to
be only marginally responsible.

The accusation that the years of the Bush Administration
was characterized by deregulation is wildly at variance with
reality. The politically ambitious hypocrite
Eliot Spitzer elevated himself from New
York Attorney General to Governor by his use of the 1921 Martin Act
(an antifraud statute that relieves prosecutors from proving
criminal intent) to extract costly settlements from Wall Street
firms. As the "people's crusader against Wall Street"
Spitzer drove the CEOs of AIG and other firms from office, with
disastrous results for those firms and for the economy. The
Sarbanes-Oxley Act of 2002 (enacted
in reaction to the Enron, WorldCom and Tyco accounting scandals)
imposed costly accounting regulations that were particularly
onerous for small firms. The number of American companies
deregistering from public stock exchanges nearly tripled after
Sarbanes-Oxley became law, and there were few new foreign listings
on the New York Stock Exchange. Even New York's liberal Democratic
Senator Charles Schumer sought revisions to reduce the exodus of
companies to overseas stock exchanges. The 2007 imposition of
mark-to-market accounting by the SEC greatly amplified the
crisis created by securitization of subprime mortgages.
The two terms of the Bush
Administration was associated with a 68% increase in spending
on regulatory agencies — greater than the increase associated
with the administrations of any of the six preceding Presidents.

In 2011 the Federal Reserve purchased 61% of U.S. Treasury
securities, in contrast to negligible amounts purchased before the
2009 financial crisis — artifically depressing interest rates
on Treasury bonds during a time of massive deficit spending financed
by government borrowing. Foreign purchases of Treasury securities
declined to 1.9% of GDP in 2011 compared to
6% of GDP in 2009, and U.S. private sector
purchases declined to 0.9% of GDP in 2011 compared
to 6% of GDP in 2009. In 2012 the Fed began expanding
its "Operation Twist" to purchase bonds of longer maturity
— a departure from its historical practice of operation at
the short end of the yield curve — to drive down long-term
interest rates. Fed holdings of bonds with maturities exceeding
5 years were increased by over $500 billion.

Massive Money Creation by the Federal Reserve

In December 2011 the SEC announced lawsuits against six
top executives of the Fannie Mae and Freddie Mac. The SEC
charged that the GSEs hid the size and riskiness of their
subprime mortgage holders from investors, ratings agencies,
and financial regulators. Ironically, also in 2011, the
Federal Housing Finance Agency (the government
agency controlling the GSEs) sued 18 financial institutions for
misleading the GSEs about the quality of loans underlying the mortage
bonds sold to the GSEs. By the end of 2013 the FHFA had reached
settlements with 6 of the 18, collecting $7.9 billion.

It was the unregulated GSEs, their crony pseudo-capitalists,
and their pork-barrel political allies who wrecked havoc on the
financial system — with help from the misguided
economic policies of Keynesians & Monetarists.
Business people were responsible to the extent that they
were bullied by politicians into making bad loans, or
relieved of any responsibility for being concerned about
risky loans because of implicit government guarantees.
Loans were made to people who could not repay them rather than
to businesses that could have used the money to increase
production & employment.
The naive belief that politicians & bureaucrats have
the morality & competence to regulate businesspeople
&amp the economy can only lead to waste, economic chaos
and loss of freedom. This is not to say that no politician
or bureaucrat has ability or good intentions, but they
should not be regarded as divine beings and it is wrong
to think that their judgments are superior to those that
result from free competition subject to laws against fraud.
Too many people think that the economy is too important to
be left to the market, but it is instead the case that the
economy is too important to be left to the politicians
and bureaucrats.

The goals of the Obama Administration are to follow the example
of Franklin Roosevelt during the Great Depression, by Keynesian
spending programs intended to create jobs and "stimulate the
economy". Government money can only come from taxing or
borrowing money from people who would have otherwise invested the
money more productively. The Bush Administration was an example
of massive government spending increases that hampered
economic growth.

Gordon Tullock, an economist who helped found "public choice" theory, wrote
a critique titled "Why the Austrians are Wrong about Depressions" based
on an account Austrian economist Murray
Rothbard wrote to explain Austrian theory to the general public. Tullock said
that Austrian economists are hypocritical in crediting entrepreneurs with such
wisdom in resource allocation, but so much stupidity in not being able to avoid
being misled by central bank interest rates.

Austrian economist Roger Garrison
has compared central bank interest rates to a jammed radio signal — one can
know that the signal is jammed without knowing what the unjammed signal is. Even
if most businesspeople understood Austrian theory, the challenges of knowing how
much the central bank is distorting natural interest rates may be more than most
businesses, especially smaller businesses, can accomplish. Undoubtedly some
businesspeople learn to anticipate the effects of central banks, but not enough to
nullify their effect. Instead of businesspeople being guided by market realities,
they get caught in a dysfunctional cat-and-mouse game of trying to second-guess
the Fed, who is trying to second-guess business and speaking in tongues so
as not to be second-guessed. If there is a widespread expectation that interest rates
will be raised, investment & spending may be deferred — leading the Fed
to not raise rates. Stock market sell-offs because of low unemployment (indicating
a healthy economy, but also suggesting that the Fed may raise interest rates)
are an abberration produced by the Fed's choke-hold on economic activity.
Investors profit from guessing how the Fed is being manipulated by political
forces rather than by discovering opportunities for capital to increase
production of wealth. Prudent businesspeople must compete with ill-conceived
start-up companies to keep competent engineers, lawyers and executives —
thereby driving up their costs even if they are aware of the artificial
credit-expansion. The availability of apparently cheap capital is a hard
temptation to resist when faced with the threat of competitors who are
expanding their businesses. The broadening of credit beyond the business sector
has also widened the scope of influence of economic manipulations by the Fed
— as seen in the American housing boom & bust.

Tullock asserts that even if capital has been malinvested into building
too many factories, apartment buildings, airplanes and other expensive
machinery, that these items can still be used to produce useful goods &
services — benefiting the economy. But extra factories & airplanes
will not be used when existing ones are more than adequate to cover
depressed demand. There is no incentive to complete partially-finished
projects that have no hope of justifying the costs. Distorted interest rates
will have caused wasted economic activity which detracts from production
of wealth, contributing to depression & unemployment.

Tullock describes economic ups and downs as a "random walk"
rather than a cycle. But Austrian economists are not saying that business
cycles are a sine curve. The cycles follow the market-distorting movements
of central banks that lower interest rates to "stimulate the economy"
or raise interest rates to "fight inflation" — purportedly aloof
from political influence. Tullock sees nothing much wrong with inflation,
and sees no reason why central banks should trigger recession by hiking
interest rates. But inflation feeds on itself as people begin to
anticipate inflation. People stop saving and will buy any real goods
as a means of holding on to value — causing the inflation to exceed
government monetary expansion. The devastating effects of inflation
on economic planning & material well being are too great for
central banks, politicians or voters to ignore.

Economist Paul Krugman has criticized Austrian theory with even less
effort to learn about it than Tullock. In his essay
"The Hangover Theory"
Krugman does not even understand the necessary connection in
Austrian theory between the malinvestment boom following
central bank interest rate policies — saying that in Austrian theory
the boom could as easily be due to "irrational exuberance"
of entrepreneurs. Krugman wrote that Austrian
theory merely describes business cycles without explaining them.
Krugman complains that all industries suffer in a recession,
not just the investment sector. But Austrians would say that
central bank rate tightening to fight the inflation it has
created will depress demand in all sectors. This is all the more
true because of the widespread use of credit in modern society,
as noted in the American housing crisis. When Austrian theory
was formulated use of credit was more restricted to business activity.

As a Keynesian Monetarist, Krugman believes the cure for
depressions & recessions is for central banks to "stimulate
the economy". Instead of reasoned criticism of Austrian theory,
Krugman dismisses it as a prudish moralism against the
idea that government printing of money can have a positive effect.

Economist Bryan Caplan, unlike Tullock or Krugman, has studied
Austrian economics before criticizing it. Section 3.4 of his
essay "Why I Am Not an Austrian Economist" deals with
his criticisms of Austrian Business Cycle Theory. Much of his
criticism is along the lines that Austrian economists are wrong
to think that they have ideas that are distinct from ones that
are part of modern neoclassical economics. Caplan is lucid in
his explanations about why Rothbard is wrong to attribute all
wage rigidity to governments & unions and about why all
durable goods production — rather than just capital goods —
would suffer from depression/recession (somewhat in agreement
with the analysis of the American housing sector boom &
bust discussed in the previous section).

Caplan claims that Austrian theory predicts that output will
increase during depressions, but it is not clear why he would
believe this — especially in light of his lucid analysis of
durable goods. If Austrian theory did predict an increase in
production in depressions it would clearly be wrong on that
point, but the essential thesis of Austrian business cycle
theory is that manipulation of interest rates by central
banks is the cause of boom & bust market distortions.

Caplan's strongest objection to Austrian business cycle
theory is that it "requires bizzare assumptions about
entrepreneurial stupidity in order to work: in particular, it
must assume that businesspeople blindly use current interest
rates to make investment decisions." As discussed in
connection with Tullock, it may be far more difficult for
people to anticipate future interest rates than academic
economists assume — especially when so few are familiar
with Austrian theory. If more people understood the
damage caused by central banks, they would be abolished —
along with all government-created money.

Austrian business cycle theory was formulated during
an age when most borrowing was done by businesses to
finance business activity. Nonetheless, the essential thesis
that artificial interest rates by central banks creates
an inflationary "boom" that misallocates
resources remains true, even if the effect is not always
initially on capital goods. It also remains true that the central
bank will ultimately be forced to contain the inflationary
nightmare that it has created by tightening interest rates
and creating a "bust" (recession/depression).

How can it be said that a free economy — a capitalist
society — exists anywhere in a world where money & interest
are so heavily influenced by central banks? Fascism and
socialism are more appropriate words for economies wherein
money & interest is deemed to be so important that
only benevolent dictators can be trusted to control them.
If market forces cannot be trusted to set prices for
money (interest rates) why shouldn't government control
the price of food, cars, computers and everything else?
Just as business people take the blame for rising prices when
governments inflate money, depressions & recessions are
blamed on greedy capitalists rather than central bankers —
and there is demand for more regulation. If regulation were
the answer to prosperity, totalitarian Russia would have
thrived instead of collapsed. The efforts of Keynesians or
Monetarists to "stimulate the economy" by government
spending or expanding the money supply are like
18th century physicians trying to cure patients with bloodletting.
Governments only get money by taxing, borrowing and inflating,
so any money the government has will be taken from others
who could do more for the economy with the money than
bureaucrats or politicians could ever do. The source of
economic growth is investment in productive resources, not
consumer spending.

If enough business people, economists and citizens come
to understand the effects of central bank manipulations
there would be hope that the market could become efficient
enough to avoid boom & bust malinvestment & recession.
But if enough people came to this understanding, they might
be wise enough to abolish central banks and take money-creation
out of the hands of governments.

THE AUSTRIAN THEORY OF THE TRADE CYCLE by Richard Ebeling (Editor) (1996)
THE FED by Marin Mayer (2001)
A MONETARY HISTORY OF THE UNITED STATES,1867-1960
by Milton Friedman & Anne Schwartz (1963)
AMERICA'S GREAT DEPRESSION (Fifth Edition) by Murray N. Rothbard (2000)
IN DEFENSE OF FREE CAPITAL MARKETS by David DeRosa (2001)

ARTICLE:

WARTIME PROSPERITY? by Robert Hicks
[THE JOURNAL OF ECONOMIC HISTORY 52(1):41-60 (1992)]